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Undervaluing Income, Overvaluing Growth
April 12, 2022
In my opinion, the market is currently undervaluing income while overvaluing growth. This is not a recent occurrence, but the trend has persisted and become more exacerbated over the last two to three years. Before we unpack this statement, I first want to comment that this discussion about valuation is relative and while certain types of opportunities are “undervalued”, they are still expensive as global yields are at all-time lows and there almost no cash-producing assets which are truly undervalued.
With that being said, the most aggressive bidding wars where pricing is being stretched the most is in the value-add and growth space. Conversely, investment opportunities which present little to no upside via rent increases, expense reductions, and improved management (core/core-plus) are not seen as sexy and are less sought after. By the nature of these strategies, core/core-plus investments should yield lower returns than value-add deals since there is greater risk involved in the latter. To use some example numbers, let’s say a 12% IRR is an appropriate return for core-plus while 15% is enough to justify value-add. Without any distortion by market forces, this “risk curve”, where projected returns are positively correlated to the risk of the investment, puts many investors in a difficult position. Specifically, most private/alternative asset investors are seeking superior/opportunistic returns which are typically unavailable in the public markets. Unfortunately, this means that irrespective of current market dynamics, most real estate investors must pursue value-add, opportunistic, or development projects in order to see the projected returns they are looking for.
Using our example numbers from above, this means that if demand for value-add happens to be too strong, pricing goes up, thereby decreasing prospective returns from 15% to 13%. Meanwhile, if core-plus opportunities are out of favor, the prospective return there may increase to 13%. In this reality, the risk curve has completely flattened, leaving the returns for core-plus and value-add virtually the same, while the latter is still taking more risk from a business plan execution standpoint as well as likely relying more on a capital event to achieve the projected returns rather than cash flow. In a situation like this, a logical investor would choose the core-plus strategy over value-add but the problem is most funds and individual investors are not interested in private real estate investments for this lower, more conservative return. Instead, they choose to take more risk to try to make up for yield compression.
This dynamic of compressed returns in the value-add space is certainly a reality today which is even more interesting considering the fact that the effects of COVID on the economy have challenged many growth/value-add theses. Investors who were either banking on rent growth or the ability to renovate and raise rents by $200 may not be as successful given the recession caused by coronavirus.
Meanwhile, the core-plus space is more focused on attractive, long-term cash flow which is a lower return strategy and therefore often ignored in the non-institutional space. Additionally, while cap rates have continued to compress, making finding attractive opportunities that much more difficult, interest rates have also declined. A critical component of a successful core-plus investment and in order to generate attractive cash flow, there must be a positive spread between the operating cap rate and the cost of debt. With interest rates around 3%, it is not impossible to create a 250 basis point spread which is a historically attractive spread.
A quick math side point: Not all spreads are created equal. Even if the spread is the same but at a lower cap rate, the levered return is in fact slightly lower.
Something to be mindful of when evaluating spread and cash flow is amortization. Most loans have an initial interest-only period which can create a false sense of healthy cash flow. The importance of the “plus” in core-plus is to have some way to grow NOI over time through management improvements or ancillary income in order to still have healthy free cash flow even after amortization kicks in.
An interesting distinction between value-add and core-plus investments is the key skill set for each strategy. For value-add, sourcing and underwriting the right opportunity and then being able to execute the renovations or turnaround business plan is crucial. The majority of the value is generated based on a refinance or a sale and therefore optimizing cash flow is of lessor importance. For core-plus business plans, the hold period is longer, and the emphasis is on cash flow which means operational efficiencies are crucial. Because of the longer hold period, it is far more important to have accurate market analysis in order to pick the right location as well as a quality asset which will hold up well without the need of constant capital expenditures which can soak up any potential profits.
We continue to focus on both core-plus and value-add opportunities. We believe in the importance of responding to market forces rather than chasing returns which may or may not be there. Additionally, we focus on investing in preferred equity which is another way to reduce risk through capital structure rather than reduce risk through business plan as discussed in this article.